Playing China’s ‘One Belt, One Road’!

The Ancient Silk Road was known to be the stuff of legends, inspiring many of our ancestors back in those days enthralled by adventure and mystery.

The famous Venetian merchant Marco Polo recorded his journey across Asia through this ancient travel and trade route, which for centuries, have allowed merchants, traders, travellers, missionaries and diplomats to exchange goods, ideas and spread cultural influences across the vast area of Eurasia.

The Ancient Silk Road declined in influence and usage because it gradually became uneconomical after the Age of Exploration that began in sixteenth century Iberia. The charting of maritime routes across the Old and New Worlds and the establishment of coastal ports lowered the costs and time needed to move goods back and forth.

Four centuries later, we find ourselves with the news that the Chinese are intending to recreate the Ancient Silk Road with the machinery of our present times, dubbing it the ‘One Belt One Road’ project. They have also announced that they will establish a series of strategic ports along sea channels and dub it the ‘Maritime Silk Road’.

The plan is to develop a massive network of trade and infrastructure for China to integrate deeper with countries across Asia, the Middle East, Europe and Africa, by leveraging on China’s financial and material resources. According to BNP Paribas:

“the project envisages building roads, railways, pipelines and industrial corridors across some 60 or more countries, requiring billions of tonnes of steel and cement, hundreds of thousands of workers, tens of thousands of cranes and diggers, and dozens of new dams, power stations and power grids.”

In essence, China is exporting its industrial might and perhaps overcapacity and investing them in strategic areas of the world that would deepen commercial ties to her and also increase strategic and geopolitical influence.

This mega-project has a long timeline, and it would probably take decades to fully materialise. Information and updates are available on the official website administered by the Chinese government.

Despite the large amount of scepticism as well as suspicion surrounding this mega-project, I believe that it highly certain that Chinese policy-makers will get their way with this. If it’s anything that we could learn over the past 37 years since China opened her doors to the world, it is that they tend to push through to their objectives with much determination, implemented with a gradual, adaptive but (ultra) long-term approach. This is of course with the assumption that China’s future leaders continue on with this policy that is pretty much the pet project of the incumbent president.

As macro investors, this is a big issue to monitor and watch. The OBOR plan has to potential to reshape the geopolitical and commercial picture of the entire Eurasia and Africa. This will influence political trends, business and social affairs as well as financial markets across the region. Corporations may change the way they integrate their value chains and the movement of human capital will shift according to the various opportunities.

How does one make money from this?

I believe that we are still in the very early stages of the OBOR plan, with many details of implementation still severely lacking at this juncture. Additionally, one vital point to note about this mega-project is that it isn’t an one way deal. Other countries taking part in it have to also do their part in order to see successful implementation. Construction deals, political agenda and financing arrangements are two-way.

But with that being said, we could still do some digging into this theme.

Some institutional and professional investors have started to attempt on capitalising on this trend. According to Fund Selector and other industry watchers, a few index providers have created benchmark indexes that supposedly represent the OBOR-related plays. One such provider is China Securities Index Ltd, with their proprietary OBOR Index. Its constituents are Shanghai listed A-shares of Chinese state-owned enterprises (SOEs). I’m quite certain that there could be more indexes created and index tracker products that come alongside it.

There are also several asset managers that have launched ‘OBOR’ theme-related portfolios and have commenced distributing them as investible products for institutional and professional investors. The issue with these approaches is that the labelling or classification of what is a ‘OBOR’ play is very vague and still unclear at this stage. Additionally, they are also not ‘pure play’ in the sense of direct exposure to the OBOR project, as these companies have diversified sources of revenue.

As for myself, I would prefer to look for niche plays (i) that will benefit from the implementation phases of the OBOR plan, or (ii) entities that would benefit from the increase of economic activity in certain regions of the world.

For plays in the first bucket (i), they would only need to generate revenue from the construction of OBOR-related projects, and not from the usage life of the assets upon, as the investment horizon would be too drawn out. The second bucket (ii) would preferably be ideal but difficult to define and implement in a portfolio. These could range from entities that benefit from increased economic activity due to a rise in human traffic, with the likes of travel/tourism to consumer-related plays.

Some listed counters that are in either buckets for consideration include:

Another way to play the OBOR theme could be to acquire exposure to frontier markets that are expected to benefit the most from its implementation. Real estate in Pakistan, tourism in Myanmar, ports along Turkey and Greece, or financial services in East African countries could all indirectly benefit…

One particular entity that I like at the moment is China Railway Signal & Communication Ltd (CRSC), which is listed in Hong Kong as 3969.HK. CRSC is a dominant provider of railway and urban transit control systems in China, and one of the world’s largest producer of rail traffic control systems. The company services all kinds of new and existing railway systems, be it backbone rail, high-speed rail or urban metro and trams. CRSC went public on the Hong Kong Exchange (HKEX) in August 2015, raising HKD 10.8 billion, with management planning to use the proceeds for research, acquisitions and overseas expansion.

As of end of 2016’s financial year, railway and urban transit consisted of about 77% of CRSC’s overall business:

In terms of overall revenue breakdown from the various services it provides, it is roughly diversified in each segment (as shown below). This makes CRSC less vulnerable to any particular service segment it offers.

CRSC’s management has been and is pushing for strategic overseas opportunities to ride on the OBOR theme. It has provided its services in countries such as Laos, Uzbekistan, Pakistan, Tanzania, Angola and Argentina thus far.

Typically, CRSC’s business moves in tandem with other SOEs such as China Railway Engineering Corporation and China Railway Construction Corp, which either lead the bidding for projects within China or for foreign projects, or subcontracts them to CRSC. Thus, it’s imperative to watch the industry’s bids and future ventures into various parts of Central Asia and Africa for growth potential.

In terms of balance sheet strength, the company has been modest in managing both its current and long-term liabilities. Here’s its common size adjusted BS statement:

What I like about CRSC as compared to other infra-related peers (that could all benefit from OBOR) is its relatively high margin nature of its business due to the niche nature of its services. Historical adjusted EPS has also been on an healthy uptrend:

As of 11 August 2017, CRSC is trading at a 12-month forward PE ratio of around 13.0X. It sports a 1.9% estimated dividend yield as well. Valuations are pretty reasonable considering the growth opportunities – a fair valuation PE multiple could be in the range of 15.0X to 17.0X for such a company. I like the relatively-muted interest surrounding many of these companies and the fact that it is generating recurring revenue from its existing contracts and projects on the Chinese mainland (97% of overall revenue). The company can continue enjoy earnings growth opportunities even with declining rail additions. Its future growth potential would be greatly expanded with the incremental rolling out of OBOR projects across Eurasia and Africa.

Here’s a glance of CRSC’s historical stock price since it went public, courtesy of InvestingNote:

On the weekly price charts, price has been hovering in a range between 6.40 and the lower level of 5.50 since early October 2016. This is a nice development, and I may consider an entry position for the core portion of my portfolio if price breaks above the resistance zone of between 6.40 – 6.50, with a holding period of 9 – 18 months. This area allows a tight risk point for a long trade, with an implied price target of 7.44 as implied by the weekly chart range. If price does not cooperate and breaks below the current lower range, I will obey price action and lay off an entry for the moment.

Sell-side analysts have a consensus ‘buy’ rating on CRSC, as shown below:

Because of the long-term nature of this theme, I would classify CRSC as a beta play in my own portfolio. Additionally, due to the nature of its business as well as its revenue sources, CRSC is highly uncorrelated to the drivers of other long equity positions I have and plan to build (it has a historical beta that is under 0.9X). CRSC is a great way of playing China’s exporting of her excess industrial capacity, and I would like to add that I like the consensus’ scepticism or suspicion surrounding the OBOR theme.

In the years to come, there would be more specific and dedicated ways to benefit from China’s effort to reshape the world…